Understanding asset allocation

Most investing arguments are about the wrong thing. Which fund? Which broker? Active or passive? These matter a little. The decision that dominates them all is asset allocation — how much of your money sits in stocks vs. bonds vs. cash.

Study after study (Brinson et al. 1986 and its many successors) has found that roughly 90% of the variation in long-run portfolio returns comes from the asset mix, not from the specific securities inside each bucket. Get the mix right and the rest mostly takes care of itself.

What the major asset classes actually do

Each asset class trades expected return for some specific kind of risk. You want a mix because no single asset handles every kind of bad year.

Stocks (equities). Ownership in companies. Over 20+ year horizons they return ~6–7% real (after inflation) historically. In any given year they can drop 40%+. They are the engine of long-run compounding and the source of most portfolio volatility.

Bonds (fixed income). Loans to governments or companies. Historically ~2% real return. Much smaller drawdowns (outside 2022, which was exceptional). They tend to rally when investors panic out of stocks, which is why they’re the classic diversifier.

Cash and equivalents. Savings, money market funds, short T-bills. Roughly keeps pace with inflation — sometimes a bit better, sometimes worse. The only asset that won’t drop when you need it, which makes it the only appropriate holding for money you need in the next 1–2 years.

Real estate (REITs or direct). Long-run returns similar to stocks with different cycles. Acts as partial inflation hedge.

Alternative assets (gold, crypto, commodities, private equity). Each has a story. Most long-run data shows they underperform stocks with equal or greater risk. They belong, if anywhere, as small side allocations — not core holdings.

The classic rules of thumb (and their limits)

“100 minus your age in stocks”

A 30-year-old holds 70% stocks; a 60-year-old holds 40%. This rule built the modern target-date fund industry. It’s a reasonable starting point, but it ignores three things:

1. Your risk tolerance. Some people can stomach an 80/20 portfolio in their 30s; some can’t watch $200k drop to $120k without selling. Rule-of-thumb allocations don’t account for that.
2. Your time horizon for the money. Retirement money at 60 may not be spent until 90 — that’s a 30-year horizon, not zero. Many retirees end up too conservative.
3. Your other assets. A pension, Social Security, or rental income acts like a bond. If your guaranteed income covers most of your retirement spending, you can run a more aggressive portfolio.

”Age in bonds” (a slightly updated version)

A variant that pushes stocks higher at every age. A 30-year-old holds 30% bonds, a 60-year-old holds 60%. Better for long horizons, same caveats.

Rick Ferri’s rule of 120

“120 minus your age” — leans even more aggressive. Reflects the reality that people live longer and bond yields are lower than they were when the original rule was coined.

The three-fund portfolio

The default recommendation at Bogleheads and most fee-only advisors: three broad index funds, rebalanced once a year.

A typical 30-year-old might hold it as 60% US stocks / 30% international / 10% bonds. A 65-year-old retiree might hold 35% / 15% / 50%. Same three funds, different knob settings.

The three-fund portfolio has beaten most professionally-managed portfolios net of fees over every reasonable long-run window. Boring works.

How horizon shapes the answer

The single most important input is “when do I need this money?”

• 30+ year horizon (young accumulator): stocks dominate. Drawdowns become buying opportunities. 80–100% stocks is reasonable.
• 10–20 years (mid-career): still heavily stocks, but start introducing bonds. 70–80% stocks.
• 5–10 years (approaching goal): reduce equity risk. 50–70% stocks.
• 1–5 years (goal imminent): you care about capital preservation more than growth. 20–40% stocks.
• Under 1 year: cash / short T-bills. Do not put next year’s down payment in stocks.

Many retirees split the problem: a short-term “bucket” in cash and bonds to cover 2–5 years of spending, a long-term “bucket” in stocks that can weather any drawdown without being touched.

Tax location matters too

Same allocation, different accounts, very different outcomes. The rule of thumb:

• Tax-advantaged accounts (401(k), IRA): hold bonds and REITs. Their income is ordinary-rate and tax-inefficient in a brokerage.
• Taxable brokerage: hold broad stock index funds. Long-term capital gains and qualified dividends are taxed at lower rates, and you can harvest losses.
• Roth IRA: hold the highest-expected-return assets you own (aggressive stocks). Growth is tax-free forever, so you want as much of it here as possible.

This is called asset location (as distinct from asset allocation). It matters more the larger your taxable account grows.

How to actually pick

A useful short exercise:

1. Horizon. When do you need the money? Pick the longest-dated goal this account is for.
2. Stomach test. If this portfolio dropped 40% next year, would you sell? Rebalance? Add more? Your honest answer caps your stock allocation.
3. Other income. Is any portion of your retirement spending covered by pensions, rental, or Social Security? If yes, you can run a more aggressive portfolio.
4. Simplicity. If you can’t explain your allocation in one sentence, it’s too complicated.

Write down your target. Automate contributions to maintain it. Rebalance once a year. That’s asset allocation in practice.

Further reading

• Net Worth calculator — see your current mix across accounts
• Portfolio rebalancing, and when to actually do it — how to keep the target after markets move
• Bonds explained — why bonds deserve a slice even in accumulation years
• Index funds 101 — the building blocks of a simple portfolio